Surging M&A Activity Suggests The Worst Is Over For Oil

The second half of 2016 is shaping up to be one of the most active for M&A activity in the U.S. oil and gas industry, a sign that companies and investors are growing confident that the worst of the more than two-year downturn is over.

According to new data from the EIA, the value of the average M&A deal in the fourth quarter is set to be the highest in years. In the third quarter, there were 93 M&A announcement across the U.S. oil patch totaling $16.6 billion, according to the EIA. In other words, the average deal was worth $179 million, the highest average since the third quarter of 2014. The fourth quarter will see a much higher average, topping $400 million per deal. In addition, nine of the 71 deals that were valued at over $1 billion since 2011 occurred in the third and fourth quarters of this year, compared to just four in all of last year.

The EIA credits the sudden surge in acquisition activity to higher and more stable oil prices, which have traded at least above $40 and close to $50 per barrel since June. Also, lenders have become a bit more comfortable with the health of the market, and credit conditions have improved. The option-adjusted spread between high yield energy bonds and U.S. treasuries has declined, the EIA notes, indicating a much lower level of financial stress in the industry than earlier this year. The spread is now at the same level as it was back in November 2014 when oil prices traded at $70 per barrel. In other words, the default risk of high yield energy debt has plunged in the second half of 2016, and with less of a default risk, lenders are more willing to lend. All in all, investors and drillers are growing more confident that the market has already bottomed out and is on the rebound.

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But the reason that the average deal is worth so much more in the third and fourth quarters has much to do with the frenzy unfolding in the Permian Basin right now, where exploration companies are falling over each other to acquire acreage while they still can. The Permian Basin is home to some of the “hottest zip codes in the industry.” The land rush has inflated prices as more and more companies bid for increasingly scarce shale acreage. Land deals are now routinely topping $40,000 per acre in the Permian, and one deal in particular exceeded $60,000 per acre earlier this year.

The EIA cited a few key examples of some recent deals that exemplify the red hot interest in the Permian Basin, which include RSP Permian’s $2.4 billion purchase of Silver Hill Energy Partners and Silver Hill E&P; EOG Resources $2.5 billion acquisition of Yates Petroleum in September, which doubled EOG’s acreage in the Delaware Basin; SM Energy’s $1.6 billion purchase of Permian acreage from QSTAR LLC; and SM Energy’s $980 million purchase of Rock Oil Holdings.

But the fact that the average M&A deal is worth so much more this quarter than in recent years could be a bit skewed by what’s going on the Permian. It could just be that rigs, people, and capital are all increasingly concentrated in the same place. That does not mean that the broader shale industry is necessarily healthy. The Bakken and Eagle Ford have not rebounded in the same way, and continue to suffer from the effects of the downturn. The rig count in the Eagle Ford stood at 33 at the end of October, hovering near their lowest levels since the onset of the shale boom a half decade ago. The same is true for the Bakken.

Either way oil and gas companies and their lenders and investors will simply have to get used to paying a lot more for acreage, since the Permian appears to be one of the few areas that everyone wants to be.

Another takeaway from the EIA’s M&A data is that although activity is concentrated in the Permian, the uptick in spending on acquisitions could mean the rate of drilling continues to rise. Companies clearly think they can turn a profit at today’s prices. Indeed, Permian oil production continues to rise, and the EIA expects it to top an all-time high of more than 2 million barrels per day this month. That is up more than 500,000 barrels per day from two years ago, a remarkable feat given the crash in oil prices over that timeframe. It may not be enough to compensate for lost production elsewhere, but U.S. output is no longer falling.